FX · X8 · 9 min
FX options
Name an FX option, work out what it costs and where it breaks even, and say when a company would pick one over a forward.
In the news: “Demand for yen calls jumps”: what option prices say about where traders fear the next big move.
The essentials
- What an FX option is
- The right, not the duty, to exchange at a set rate, the , on a set date, bought for a paid up front. The strike can sit above, at or below spot.
- A call on one is a put on the other
- The right to buy euros with dollars is also the right to sell dollars for euros, so it is named both ways: a EUR call / USD put. Against the pair it is a call on EUR/USD, gaining as EUR/USD rises.
- Premium and break-even
- Premiums are quoted as a % of the amount or in : 1.2% of £10m is £120,000. A call breaks even at the strike plus the premium in pips, a put at the strike minus it: a 1.0900 EUR/USD call costing 120 pips, at 1.1020.
- Option or forward
- A forward fixes the rate with nothing paid up front and no upside. An option sets a worst rate and keeps the upside, for the premium, so it suits money that may never arrive, such as a bid for a foreign contract.
- Risk reversals
- A compares out-of-the-money calls with equally out-of-the-money puts on the first currency. Positive means the calls cost more: the market is paying to protect against the pair rising.
Break-even and premium
Call break-even = K + premium; put break-even = K − premium; premium = % × notional
- K
- strike, in terms currency per unit of base
- premium
- in terms-currency pips per unit of base, for the break-even
- %
- premium as a % of the notional it is quoted on
How it works
1. A right, not a duty
A forward obliges you to exchange. An option gives you the choice: the right to exchange at a set rate, the , on a set date. You pay for that choice up front with the .
2. A call on one is a put on the other
The right to buy euros with dollars is also the right to sell dollars for euros. So FX options are named both ways: a EUR call / USD put. Seen against the pair, it is a call on EUR/USD: it gains as EUR/USD rises.
3. Strikes can sit anywhere
The strike can be above, at or below today’s rate. A call with a strike below spot would already pay if used now: it is in the money. A call with a strike above spot is out of the money.
4. The premium in money
Premiums are quoted as a % of the amount or in pips. 1.2% of £10m is £120,000. A premium of 85 dollar pips on £10m is £10m × 0.0085 = $85,000. To turn a % into pips, multiply by spot: 1% at 1.27 is 0.0127, or 127 pips.
5. Break-even
At expiry a call pays spot minus strike, if that is positive. To profit overall it must also cover the premium, so break-even = strike + premium for a call, and strike − premium for a put. A EUR/USD call at 1.0900 that cost 120 pips breaks even at 1.1020.
6. Option or forward
A forward fixes the rate: nothing to pay now, but no upside. An option sets a worst rate and keeps the upside, for the premium. It suits money that may never arrive, such as a bid for a foreign contract. A zero-cost buys one option and sells another to pay for it.
7. Risk reversals
Dealers quote options by : the size of moves the price assumes. A compares out-of-the-money calls with equally out-of-the-money puts on the first currency. Positive means the calls cost more: the market is paying to protect against the pair rising.
8. Knock-outs
A knock-out, one kind of , dies if spot touches a set level before expiry. A EUR call at 1.0900 that knocks out at 1.1300 stops paying just when it would pay most, so it costs less than a normal option.
Worked example
A UK importer must pay dollars in three months and fears a weaker pound. GBP/USD spot is 1.2700. It buys a three-month GBP put / USD call on £10m, strike 1.2500, for 1.0% of the sterling amount.
- Premium: 1.0% × £10m = £100,000, paid now.
- If cable ends at 1.2000, use it: £10m at 1.2500 buys $12.5m, against $12.0m at spot.
- If cable ends at 1.3200, let it lapse and buy dollars at spot.
- Premium in pips: 1.0% × 1.2700 = 0.0127, or 127 pips.
- Break-even: 1.2500 − 0.0127 = 1.2373.
£100,000 buys a worst rate of 1.2500 (break-even about 1.2373) and keeps the gain if sterling rises.
Check yourself
8 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
When would a company prefer an option to a forward?
What does a positive 25-delta risk reversal in USD/JPY tell you?
What’s a knock-out option, and why is it cheaper?
Remember
Call break-even = strike + premium in pips
An FX option is a call on one currency and a put on the other; it sets a worst rate for a premium, where a forward fixes the rate outright.